Putting Things Into Perspective

Golds been slowly rising over the past couple of years but it hasn't attracted a lot of attention, yet. Gold's bull market is solid, however, and it's now poised to rise to new bull market highs in the months ahead.

Interestingly, silver, and gold and gold shares seem to be anticipating the rise. Silver shot up this month to a one year high while silver shares soared. We don't think it's a coincidence that silver is now flexing its muscles for the first time in years at a time when gold is ready to rise further.

Gold shares are even more sensitive. The HUI gold share index hit a new bull market high. Plus, gold shares are now strongly outperforming gold. This too suggests the upcoming gold rise will be impressive.

The overall foundation is strong for gold, both technically and fundamentally. But the big news this month was the sharp drop in U.S. bond prices. Surprisingly though, gold and bonds are linked, and the rise in gold and drop in bonds are a reaction to what's been happening.

Considering the overall environment, we thought this would be a good time to review some of the most important happenings and try putting them into perspective. This will help explain why gold is likely headed higher.

Inflation or Deflation?

For a long time, the forces of deflation and inflation have both been pulling at the global economies. Over the past few months, deflation pressures intensified with import and producer prices plunging at double digit rates in the U.S.

The Federal Reserve (Fed) has been very concerned about deflation and it's been pumping out money like mad while dropping interest rates to near zero to keep deflation from taking hold. Its actions have been inflationary, which is why these two crosscurrents, inflation and deflation, have been bucking heads.

China: A deflationary force

But the Fed can't control China and that's where a lot of the deflation pressures are coming from. Since China is the world's largest producer of inexpensive goods, consumers have been buying these products like hotcakes. Chinese exports have tripled over the past nine years. So manufacturers outside of China have had to keep prices low to compete.

Plus, with help from global companies, China has been building factories, in part with all the dollars that've been flooding in, which has transferred millions of factory jobs from the U.S. to China where workers make a fraction of what U.S. workers make. This has kept U.S. unemployment high since factory jobs have accounted for 90% of job losses over the past couple of years and it's estimated that over three million U.S. jobs will be sent overseas over the next decade or so.

Growing Debt Monster

At the same time, the massive U.S. trade deficit and low interest rates have caused the U.S. dollar to fall. But a weak dollar and low interest rates are needed to help fight off deflation pressures, which have been keeping the economy sluggish. Then there's the federal debt, which is also a drag on the economy.

Just since the 1990s, for example, the U.S. government has accumulated more new debt than all the debt that was built up since the U.S. became a nation. So the U.S. is dependent on the rest of the world to keep accepting their paper dollars in exchange for goods. But the U.S. thirst for consumption, debt and military adventure cannot continue as is. Something's going to give and it may already be happening.

Debt and Bonds

The government finances its debt by selling bonds, and foreign investors hold about 40% of U.S. government debt. But as Stephan Roach notes, there comes a time when foreigners demand a premium for funding a savings-short economy. The breaking point usually occurs when the current account deficit hits 5% of GDP. That typically triggers the classic current account adjustment characterized by a weak currency and higher real interest rates.

The U.S. is now at 5.1% of GDP, which require inflows of about $2 billion a day, and it could grow to 7% by the end of next year. So there's a real possibility foreign investors are now looking for compensation in the form of rising real interest rates, which could explain in part why bond yields have been soaring.

The Fed also buys bonds by creating money out of thin air. This helps fight deflation too but the extra money created is inflationary. For now, the economy is picking up, but that doesn't mean it's out of the woods.

The decline in U.S. bond prices, however, suggests that deflation pressures are easing and inflation has become a concern. The record spending and deficits nearly guaranty it because the Fed will have to keep the money flowing to cover ongoing expenses, now estimated at a $44 trillion shortfall for the years ahead. But the puzzle is still unfolding and neither scenario is a done deal. This month's sharp rise in long-term interest rates, for instance, also drove mortgage rates up to over 6%. And since mortgage refinancing has been a big factor keeping the U.S. economy afloat because it kept consumers spending, it's now worrisome that refinancing has dropped more than 50%. Consumer confidence also declined to a four month low and these two factors could threaten not only the U.S. recovery, but the global economy as well, because the U.S. is the world's engine and consumers drive the U.S. economy. If the consumer cuts back on spending, everything could grind to a halt, again increasing the deflation risk.

In fact, the public is beginning to sense all is not well. Bush's popularity has dropped 29% over the past few months due to his justification for going to war, the casualties in Iraq and expenses of $4 billion a month to keep 150,000 troops there, the deficits, but mainly because of the economy and unemployment.

What does this mean for the markets?

Just look at the chart and it'll tell you. Massive debt and deficits for years to come are keeping the U.S. dollar down and it's fueling gold's bull market. Gold has clearly been the winner and since gold and the dollar move in opposite directions, as the dollar heads lower, more investors will turn to gold because it's real money and it represents safety.

If inflation picks up, it'll be super bullish for gold. But even if deflation gets the upper hand, the Fed would have to create even more money, which would be bearish for the dollar and bullish for gold. Basically, gold rises during uncertain times, and these are uncertain times.

Low interest rates are also bullish for gold. Gold pays no interest but since short-term interest rates are now extremely low, they're not competing with gold and it becomes more attractive.

In fact, demand for gold has been picking up. Plus, gold producers have been lifting their hedge policies and gold production declined last year for the first time in seven years. Growing demand with less supply is a bullish combination. Not to mention the fact that China is buying gold and encouraging its one billion population to buy too.

Bonds, on the other hand, have turned down sharply and stocks are looking vulnerable for the months ahead. If these two markets eventually head lower as we suspect, gold's glitter will shine even brighter.

On the technical side, gold is very bullish. It's major trend is up above $334. A new rise we call C is now beginning and it tends to be the best rise in the cycle. The C rise is underway as long as gold now stays above $350 and it'll gain momentum above $365. But once gold closes above its February high at $380, it'll then be on its way to our target at $415. Above that level, $500 would then be the next target. Based on average timing, this C rise could last until October.

As for silver, if it closes clearly above the $5.10-$5.20 area, it could rise to near the $6.50-$7.00 level. Gold shares are already very bullish. But if the XAU gold share index closes and stays above 88, a major six year bottom will be complete and they could then soar with the XAU eventually rising to the 160 area. This alone is exciting because if the C rise performs as it consistently has over the decades, a clear breakout for the gold shares could happen at any time.

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